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Are REITs Threatened by a Weak Economy?

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The latest weaker-than-expected ISM numbers and lower job additions make a rate hike look like a far-away event. This brings some near-term security for REIT investors.

Is the Economic Slowdown a Blessing for REITs?

Obviously not. If economic activities slow down, the fortunes of this special hybrid asset class would suffer as well. In fact, fewer job additions and a thinner purse can prove detrimental for several asset types. Demand for office space could be at stake if fewer jobs are created. Moreover, the ability to pay higher rents for apartments could be dented.

A thinner purse also lowers one's purchasing capacity, leading to softer demand for retail goods. This could end up in less store openings and reduced demand for spaces from retailers in malls and shopping centers. Moreover, lower demand for retail goods and weaker-than-expected manufacturing activities may lead to a slump in demand for distribution facilities.

Ultimately, if economic activity slows down, chances of any recovery in the fundamentals would remain elusive for an extended period. Vacancies would increase and the ability to charge higher rents by landlords would fall.

Specific Market Weakness

There are also specific market weaknesses that can dampen the growth momentum of the real estate landlords. Take for example the apartment REITs. For them, a rise in supply in many of the markets raises an alarm. This is because higher supply usually curtails the landlord's ability to demand higher rents and leads to lesser absorption.

In fact, the increase in deliveries of new units has already kept industry behemoths like AvalonBay Communities Inc. ( AVB ) and Equity Residential ( EQR ) on their toes.

For AvalonBay, revenue growth remains constrained in New York City due to higher supply. Moreover, in the urban submarkets of Boston and Seattle, significant new supply is delivered compared to the suburban submarkets. This is leading to a slowdown in urban growth rates.

Even for Equity Residential, in the balance of 2015, a number of the company's markets are expected to witness elevated deliveries. As a result, new leasing is anticipated to face pressure and pricing might be adversely impacted in such regions with elevated supply. Markets such as Washington DC, Brooklyn and Irvine are specific areas of concern because of this.

Moreover, for the Hotel/Lodging REITs, though supply in the West Coast is low and fundamentals are strong, higher supply on the East Coast and overall pricing weakness continue to restrict RevPAR (Revenue Per Available Room) growth in the region. Also, weaker-than-expected demand for hotels during August and September made some hotel REITs like Host Hotels & Resorts, Inc. ( HST ) and Pebblebrook Hotel Trust ( PEB ) revise their Q3 and full year 2015 estimates downwards.

Dollar Strength Adds to Difficulties

Strengthening of the dollar also add to the woes. Due to strong dollar, properties situated outside the country are being adversely impacted. Moreover, with the dollar gaining strength, U.S. exports have become more expensive and, are therefore losing value on the competitive landscape. That can prove to be a headwind for the office REITs as corporate leaders now have to deal with unfavorable currency movements and think twice before expanding their business.

Rates Cannot Stay Low Forever

Finally, a low rate environment cannot be a perpetual one. And when rates go up, interest costs for REITs would increase as these companies usually look for both fixed and variable rate debt financing to pay back maturing debt, and fund their acquisitions, development and redevelopment activities.

Therefore, REITs cannot practically run away from the impact of a rate hike. But the extent of such an impact would depend on the nature of their leases and funding activities. While REITs having shorter leasing periods have the power to adjust their rent quickly to adapt to the rates hike, those with longer leasing periods are left in the lurch.

Take for example the Healthcare REITs that usually have significant exposure to long-term leased assets. The long-term leases carry fixed rental rates that are subject to annual bumps. But their debt obligations bear floating rates with interest and related payments rates varying with the movement of LIBOR, Bankers' Acceptance or other indexes. Therefore, as the rates rise, the cost of borrowing increases but their revenue flows do not get adjusted quickly for their fixed-rate nature, leading to an adverse impact on profitability.

Consider Mortgage REITs that offer real estate financing through the purchase or origination of mortgages and mortgage-backed securities (MBS). These REITs fund their investments with equity and debt capital and earn profits from the spread between interest income on their mortgage assets and their funding costs. Though these types of REITs have started adjusting their strategies and business models, these companies bear long-term risk as interest rates will eventually rise.

REITs to Avoid

Specific REITs that we don't like with a Zacks Rank #5 (Strong Sell) include American Capital Mortgage Investment Corp. ( MTGE ) and Invesco Mortgage Capital Inc. ( IVR ), Ventas, Inc. ( VTR ) and CareTrust REIT, Inc. ( CTRE ) as well as Zacks Rank #4 (Sell) stocks such as Select Income REIT ( SIR ), Campus Crest Communities, Inc. ( CCG ), STAG Industrial, Inc. ( STAG ), Sotherly Hotels Inc. ( SOHO ), Sabra Health Care REIT, Inc. ( SBRA ), Terreno Realty Corp. ( TRNO ) and American Capital Agency Corp. ( AGNC ).

Bottom Line

Despite having many positives, there is no shortage of negative factors. Therefore, investors should satisfy themselves by dispassionately absorbing both sides of the argument and then call the shots.

Check out our latest REIT Industry Outlook here for more on the current state of affairs in this market from an earnings perspective.

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VENTAS INC (VTR): Free Stock Analysis Report

TERRENO REALTY (TRNO): Free Stock Analysis Report

STAG INDUSTRIAL (STAG): Free Stock Analysis Report

SOTHERLY HOTELS (SOHO): Free Stock Analysis Report

SELECT INCOME (SIR): Free Stock Analysis Report

SABRA HEALTHCR (SBRA): Free Stock Analysis Report

PEBBLEBROOK HTL (PEB): Free Stock Analysis Report

AMER CAP MTGE (MTGE): Free Stock Analysis Report

INVESCO MORTGAG (IVR): Free Stock Analysis Report

HOST HOTEL&RSRT (HST): Free Stock Analysis Report

EQUITY RESIDENT (EQR): Free Stock Analysis Report

CARETRUST REIT (CTRE): Free Stock Analysis Report

CAMPUS CREST CM (CCG): Free Stock Analysis Report

AVALONBAY CMMTY (AVB): Free Stock Analysis Report

AMER CAP AGENCY (AGNC): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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